The capitalization rate (cap rate)
can be used to compare one property to another. The cap rate is figured by dividing the NOI by the value of the property. This is also the “cash-on-cash” return if you simply purchase the property outright, without a mortgage, or will be your cash-on-cash return once you pay off the mortgage.
If you purchase a property for $100,000 and the gross rent is $1,000 per month, or $12,000 per year, then your NOI is $12,000 x 55%, or $6,600, and your cap rate is 6.6% ($6,600/$100,000). As a general rule, a cap rate of 6% to 8% is pretty good, a cap rate of 3% to 4% is not good, and a double-digit cap rate is excellent. Your cap rate is heavily affected by the purchase price. If you had purchased that same property for $140,000, your cap rate would be just 4.7%. If you were able to purchase the property for $80,000, your cap rate would be 8.25%.
Your cap rate is the equivalent of a stock dividend. While the property is likely to increase in value at about the rate of inflation as you are able to increase the gross rents, the net operating income is really what is going to provide most of your investment return, both as cash flow and as amortization on any mortgage you may have on the property.
If you buy a 6% cap rate property for cash and the property appreciates at 3% per year, then your return will be 9% per year. You may also be able to get some significant tax breaks as you depreciate the property; but if you sell the property prior to your death, that depreciation will mostly be recaptured.
Rule 4: You Must Put Down a Significant Down Payment if You Want Positive Cash Flow
Consider again our $100,000 property with $1,000 per month rent. If the NOI is $6,600 per year, then your financing costs must be less than that in order to be cash flow positive. That means you cannot spend more than $550 per month on mortgage payments.
If you put nothing down and take out an interest-only loan at 5%, your payments will be $417 per month and you will have positive cash flow. However, you will not have any amortization of your loan; after 15 or 30 years, you will still owe $100,000 on the mortgage.
If you actually want the property paid off in 15 years so it will provide significant income in retirement, that same 5% mortgage payment will run $791, and your cash flow will be a negative $241 per month. In order to be cash flow positive on a 15-year fixed mortgage, you will need to put down over $30,000, a 30% down payment. The truth is that most traditional lenders will require a 20% to 30% down payment for investment property, anyway.
can be very beneficial to the real estate investor. Both appreciation and depreciation are magnified by leverage. If a property increases in value by 10%, but you only put 20% down, that appreciation is worth a 50% return on your money! Likewise, you depreciate the entire building on your taxes, not just the percentage equivalent to your down payment.
However, remember that leverage works both ways and comes at a cost. In a real estate downturn, a highly leveraged investor can lose far more than his original investment. The more you leverage a property, the more dependent you become on appreciation, tax benefits and amortization of the loan for your property, since the financing costs will consume your cash flow.
One of the most significant downsides of real estate investing is that the transaction costs can really eat into your return. Spending 5% when you buy a property and 10% when you sell it is not unusual. That means it would cost about $15,000 roundtrip in transaction costs for our hypothetical $100,000 property.
Those costs may very well consume five or more years of appreciation. They can be especially costly when you are highly leveraged. For example, if you only put down $30,000 on a property, and rapidly buy and sell it, fully half of your investment may go toward the transaction costs. This is one reason why many people hold on to their starter homes as investment properties.
They get to avoid the transaction costs upon moving out. Plus, they often get the lower cost of financing available only on owner-occupied properties. Minimizing transaction costs will boost your returns significantly.
Following these five rules, physician real estate investors can use investment real estate to supplement the rest of their portfolio without taking on undue risk.